So Far So Good, But Will Fed's Luck Hold Out?

As we head into the last hours of 2010, the U.S. stock market is celebrating the generosity of government. Money has flowed into stocks from a variety of sources since the most magnanimous expansion of the Fed’s balance sheet in history. Major stock indexes have jumped by five to six percent in December alone, and investor confidence is growing stronger by the day. Common stocks, which were down for the year through August, reacted precisely as government wanted after Fed Chairman Ben Bernanke announced the second round of quantitative easing at his August speech in Jackson Hole.

The always-informative Ned Davis Research highlighted the Fed’s objectives by listing four quotes, first offered in the Chartist service.

“Nevertheless, balance sheet policy can still lower longer term borrowing costs for many households and businesses, and it adds to household wealth by keeping asset prices higher than they otherwise would be.” Brian P. Sack, New York Fed, October 4, 2010.

“What happens to the equity markets, what happens to the dollar, and what happens to interest rates. Don’t be concerned with printing money! Don’t be concerned with the growing Fed balance sheet or how to unwind it! The primary purpose of QE2 is to improve our financial condition. A higher stock market is good for aggregate demand, a falling dollar improves our global competitiveness, and lower borrowing costs improve aggregate demand.” Larry Meyer, former Fed Governor, on CNBC, November 3, 2010.

“And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.” Ben Bernanke, Washington Post, November 4, 2010.

“I think we are underestimating and continue to underestimate how important asset prices, very specifically equity values are, not only for shareholders and the like, but for the economy as a whole.” Alan Greenspan, CNBC interview, December 3, 2010.

Increasing liquidity in an economy normally leads to higher asset prices. The process is not a sure-fire winner, however; otherwise government would do it constantly. Obviously there are dangers inherent in any expansionary policy. One merely has to examine the Fed’s history of success over the past decade and a half to recognize the potential negative consequences of flawed expansionary policies. Unwilling to permit a deflation of the nation’s debt bubble, the Fed attempted to promote asset inflation at the end of the last century and halfway through the current century’s first decade. Both attempts resulted in asset bubbles that burst, with terrible pain experienced in the securities and real estate markets.

Not dissuaded by the failure of their most recent efforts, the Fed governors are once again attempting to ward off consequences of the debt bubble by infusing even more debt. Could it work? Of course it’s possible, and the Fed has certainly succeeded in the short run. But history argues against it, as illustrated in copious, well-researched detail by Carmen Reinhart and Ken Rogoff in "This Time Is Different." Even current Fed governor Thomas Hoenig has characterized QE2 as “a bargain with the devil.”

Notwithstanding the Fed’s initial success, each investor has to decide whether it makes sense to bet on the Fed’s continued success, or whether it is more likely that debts will unwind over time as they have after most financial crises for centuries in a great variety of countries throughout the world. We’re certainly seeing those debt strains in several European countries, and governments are doing their best to prevent any countries from falling into default. We can’t know today whether the best efforts of governments will be able to keep the debt balloons floating. The risks of failure are high and the consequences could be sudden and severe.

I wish all of our readers and their families a happy, healthy and prosperous new year.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.